A Stock Market Model

Abstract

A stock market model is presented that advances our understanding of the portfolio-consumption policy of investors and the behaviour of capital market statistics. The model's building blocks are the Samuelson-Merton model of portfolio-consumption policy, the Gordon-Sethi extension of that model to recognize bankruptcy, the Gordon dividend growth model for pricing a share, and the assumption that the system is closed. The last assumption makes price and expected return adjust to persuade investors to hold the outstanding shares and bonds. Analysis and simulation of the model reveal, among other things, that (1) the market is more stable and it performs better when investors have increasing relative risk aversion; and (2) the average infinite horizon return on a share falls below the average realized holding period return to a degree that varies with the volatility in the latter's return. Further advances in knowledge should follow from withdrawal of the simplifying assumptions that were employed to make clear the model's basic structure.